Some topics are more controversial than you may think -- like rebalancing portfolios. I've long been familiar with the concept, but I hadn't taken the time to think through the arguments.

First, the basics. Imagine that you've decided to distribute your $100,000 nest egg into the following investments:

  • 50% in a domestic large-cap index fund.
  • 10% in two bond funds.
  • 10% in a small-cap U.S. stock fund.
  • 10% in a mid-cap U.S. stock fund.
  • 10% in an international stock index fund.
  • 10% in individual stocks you've selected yourself.

(I'm not necessarily suggesting that this is anyone's ideal portfolio -- it's just an example.)

After a few years pass, you may find that your portfolio has grown to be worth $140,000, but the allocations have changed. You now have, for example, 20% of your portfolio in the international index fund. A rebalancing advocate would suggest that you should sell off some of your holdings and buy more of the other holdings, to get your international fund once again representing just 10% of your nest egg.

Why rebalance?
Rebalancing is good mainly because it prevents your portfolio from becoming too dominated by one or a few investments. As one holding swells, its performance will develop an outsized effect on the portfolio. And if it plunges, your portfolio will take a bigger hit than it would have at the original proportions.

Here's another persuasive reason to rebalance. I ran across this tidbit in the ETF Investing Guide at

It's an automated mechanism for buying (relatively) low and selling (relatively) high. As those tech stock funds go up, you sell them; as bond fund prices fall, you buy them. Then, when tech stocks crash, you buy them again, and as bond funds rocket, you sell them. ... So rebalancing is an automated mechanism for making money.

Why you might not want to rebalance
After taking in all of that information, I was surprised to learn that investing legend and small-investor advocate Jack Bogle, the father of the index fund, recently came out against rebalancing. His recent study on it included the following findings:

  • Take a portfolio made up of 48% S&P 500, 16% small-cap, 16% international, and 20% bond index. This portfolio has, "over the past 20 years, earned a 9.49% annual return without rebalancing and a 9.71% return if rebalanced annually." He concluded that the difference is rather meaningless. That sounds right, considering that the buying and selling involved in rebalancing will likely generate trading commissions.

  • Bogle also referred to an earlier study of every 25-year period since 1826 (you read that right!), which assumed a portfolio divided 50-50 between U.S. stocks and bonds: "Annual rebalancing won in 52% of the 179 periods. Interestingly, failing to rebalance never cost more than about 0.50%, but when that failure added return, the gains were often in the 2%-3% range; i.e., doing nothing has lost small but it has won big."

The ETF Investing Guide also offered a good reason to consider not rebalancing. It pointed out that some asset classes (such as U.S. stocks, bonds, and real estate) tend to trend strongly upward in a jagged line. With them, selling near the top and buying near the bottom can be profitable. But with other classes, such as Japanese stocks (and I'd add gold here, to some degree), it might not work out so well. You'd end up selling winners to invest in something that fell -- and might stay down for a very long time. As the site explains: "If asset classes do not trend upwards together in the long run, then rebalancing pushes an investor to move funds from asset classes that appreciate to asset classes that go nowhere or depreciate."

What to do
I'm blessed -- or perhaps cursed -- with the ability to often see both sides of an issue. This one is no exception. Both sides make some good sense. But here's my bottom line for myself -- and yes, your mileage may vary: Don't rebalance automatically, but do examine your portfolio now and then with rebalancing in mind. See whether you're comfortable with your current allocation proportions. This is especially important with individual stocks, since they can be more volatile than other investments. Long ago, shares of AOL (now part of Time Warner) had grown to represent more than 50% of my portfolio. My mom urged me to sell, but I hung on, greedy for more. If you don't know what happened next, you can read my story about it.

Consider letting your winners run, as long as they don't seem very overvalued. If they seem to be riding a bubble, then paring back might be smart.

Even if you decide you're very much against rebalancing, don't take that too far. If any holding's proportion in your portfolio changes drastically -- going from 5% to 30%, perhaps -- consider selling some of it. The kind of rebalancing that financial advisors often recommend will happen when a 10% stake becomes an 11% or 12% one. To me, that doesn't cry out for immediate attention.

Learn more
Rebalancing is one of the many critical topics we address in our Motley Fool Rule Your Retirement newsletter, which you can try for free. You'll get full access to all past issues, so you can gather valuable tips and even read how some folks have retired early and well. It regularly offers recommendations of promising stocks and mutual funds, too.

Longtime Fool contributor Selena Maranjian owns shares of Time Warner, which is a Motley Fool Stock Advisor recommendation. For more about Selena, view her bio and her profile. The Motley Fool is Fools writing for Fools.